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NSEL Might Have “Dummy” Stocks in What Seems To Be a Financing Scheme

The NSEL problem gets more complicated. It’s now a case of borderline fraud, it seems. Remember the owner of the NSEL (National Spot Exchange), Financial Technologies, lost 65% in marketcap yesterday when news came in that NSEL had stopped trading of nearly all contracts, and will delay payments on current ones by 15 days.

Business Standard talks about how brokers have used the exchange as a multi-leg financing scheme:

The exchange offered two contracts in raw wool. While one, RAWWOOLH2, was settled on a T+2 basis (deliveries and payouts had to be completed two days after the transaction), the other, RAWWOOLH25, was settled on a T+25 basis (deliveries and payouts had to be completed 25 days after the transaction). The contracts could be bought with an initial margin of two per cent.

Officials familiar with the functioning of the exchange said these twin contracts allowed traders to devise pair trade strategies, which allowed them to bet on the commodity without actually holding too much stock.

The price differential between the two contracts amounts to a clear 18-per-cent-a-year return for traders. "The settlement cycle allowed traders to buy the near contract and sell the far one and pocket the difference," said an official. By rolling over these contracts, consistent returns could be made for sustained periods.

Who’s on the other side losing 18% per year? It could literally be anyone that wants credit, which is being offered at 18% a year through this system. That is cheaper than most other sources, especially for sectors like real estate which aren’t getting any more formal credit.

Since a spot market mandates delivery, I actually have to take delivery of all that wool for one contract, and give that wool back for the other. However, if the warehouse is on a wink-nudge basis, I can ask them to offset both entries. This is illegal, but hey, who’s getting hurt here? Until you reach a point where buyers refuse to participate, or where people who realize it’s illegal take action:

What happens to all the wool? The wool is stored in a warehouse in Ludhiana. For storing raw wool, the exchange had mandated four godowns in a village called Seerah, near Ludhiana. The godowns were said to be in the premises of ARK Imports. Ministry of Corporate Affairs records show ARK was incorporated in 2011. Three individuals-Anubhav Aggarwal, Rajni Aggarwal and Kailash Aggarwal (the first letters of the names are ‘ARK’) own the company, with Anubhav holding 98 per cent.

According to the latest stock position provided by National Spot Exchange on July 26, the ARK godowns were holding 11,190.5 tonnes of raw wool. According to data by Wool Industry Export Promotion Council, India’s annual wool production stands at "43-46 million kg", or 43,000-46,000 tonnes. This means the warehouse in the distant Ludhiana village held about a quarter of India’s annual wool production. Not impossible, but unlikely.

To be honest, India imports 75 million kg of raw wool (Source: Textile min), but because we consume so much of it, it’s quite unlikely that we will let 10% of consumption lie in a couple godowns for this transfer drama. More likely is that the entries were “invented” to facilitate the financing scheme.

Why don’t people just borrow directly from other people at 18%? This stupid roundabout scheme is such a pain. But we need that "feeling” of a guaranteed settlement, I guess.

The government hadn’t approved such contracts – a spot exchange is for delivery after all, and has lesser regulation. It seems they’ve been chasing NSEL for a while, with the first show-cause notice a year back. Then in June, they forced the exchange to cut contract settlement periods to 10 days, and eventually, have asked for termination of all trading.

The crisis is only because buyers aren’t willing to roll over their money any further. The people at the selling end – the borrowers, effectively – have been using the money, and can’t return it in any reasonable way quickly. (Think real estate?) And to back this up there are stock entries in godowns. But does that stock actually exist? The answer lies in the wind somewhere, and I’m sure everyone’s got a whiff.

ET has an excellent FAQ on this.

Impact: If there are dummy stocks, then this snowballs into outright fraud. The guilty must go to jail, even if they are big and powerful people. This is not “harmless” – it is criminal. If they don’t put people in jail, there will not be any confidence in the financial system at all, and we can cry ourselves hoarse about people not investing, but the problem is the lack of enforcement.

Secondly, if the drama is true, FT is in major trouble. It may find a legal way to wiggle out of some of the settlement, but this business is about trust – if it’s known that FT let defaults happen, no broker will want to trust them any longer….and that’s pretty much the end of the game.

Thirdly, the collateral damage is going to be big. There are PMS schemes that told investors they could get 15% returns through this. There are banks that somehow have exposure. There are NBFCs that have been in on the game. The impact will be known only later, but it involves a lot of well known names in the financial sector.

Finally, the need for proper regulation exists. Spot exchanges don’t have regulators, and we actually can enhance the current lot (SEBI and FMC) to work with them. Any leveraged scheme has to have adequate provisioning cover, risk control and strong enforcement – so even the SEBIs, FMCs and RBIs need to up their ante. This is not the first, and this will not be the last instance of ponzi borrowing.

  • Sanjeev B says:

    “The contracts could be bought with an initial margin of two per cent.” Two percent?? That’s 50x leverage. This is the root of the problem. Anything that trades at 2% margin will inherently have massive risk.
    Heck, in today’s volatile market, you can’t even have gold trading at 2% margins, and we’re talking about wool here.
    Most of the wool is over our own eyes, and we choose to keep it that way.

    • True. The Funda is this: As a buyer I buy a contract of Wool or castor oil or whatever, for two day delivery at say 713. At the same time I sell a 10 day contract at 718. My margin for either side is just Rs. 1.4 (2%) for two days, after two days I have to pay the entire Rs. 713 + have the Rs. 1.4 of the otehr side as margin. Eventually when I get back 718, post costs, I will make equiv of 18% per annum.
      One easy way to stall this would be to charge 20% margins of course. Or, if any person has opposite positions in the same commodity, charge 100% margin. Game over.

  • Jose says:

    Very well researched n written. Its surprising how products are created with a long term settlement in a Spot exchange in the first place ! You need such Shocks to have regulators act. Good this is happening……

  • Karthik Reddy Chintaparthi says:

    What is your opinion on the MCX ? How does this effect MCX ? Please share your thoughts.
    Thanks !

    • Well, here’s the problem: MCX is owned and controlled by FT. If FT is screwed, so is MCX. If FT is not screwed, it is the shares of FT that you should be buying.
      The other issue is trust. People who are NSEL brokers will also be MCX brokers and they will just walk away if they see defaults in the NSEL trades.
      The only rescuing thing is if FT underwrites all losses and takes all the defaults on its own head. This is unlikely, it seems, as the amounts are too large.

  • Sanjeev B says:

    Thanks, that makes it even clearer. Traders who set up this two-way trade know of course that they are lending, and lending against what is essentially 2% collateral.
    The sods who don’t know this (or do they?) are the PMS clients and NBFC depositors, who effectively lend short-term at 15% ‘assured’ annualized interest on the back of 2% collateral and the soothing warbles of a slicked-back ‘relationship manager’.

  • ARP says:

    As someone who derives part of my income from hi-tech farming (greenhouses) I find this whole commodity speculation situation disappointing.
    For farming, I have to borrow at more than 15% from the bank, mortgage my land and structure (and pay exorbitant stamp duty and registration for mortgage), provide a guarantor, insure my crops and structure and go through all the hoops. The irrigation situation is bad (and getting worse), luckily 3-phase electric supply has improved. Bribing MSEB officials to get regular electric supply is not uncommon.
    And then at the end of the crop cycle, you have to deal with the wholesalers who are more than willing to screw you out of your product.
    And I see gamblers indulging and speculation and arbitrage with more or less no “skin-in-the-game”.
    You are right, someone who indulges in commodity speculation should pay a margin of at least 20%.

  • Gold Bug says:

    FMC Chairman: Will check stocks at so called “warehouse”. – CNBC
    So what next for FT?

  • Ashwini Damani says:

    This was a fantastic article Deepak. Well researched and well explained.
    To be honest, I have myself done quite a few deals on Guar Seeds and Chilli through this exchange.
    As with all ponzi schemes, there will always be a greater fool. Thankfully in this case I wasnt the greater fool

  • fubar says:

    The most horrible part is that HNI investors who are hopefully more privy to the going-ons in the company have also been caught on the wrong foot. Where does an armchair investor stand a chance in the market?

  • Getafix says:

    Wow… So this is the reason wool prices have been rising like crazy over the past few months. The impact has been there is none to buy for carpet manufacturing which is a major consumer of woolen yarn. Resulting in far fewer orders of woolen carpets than in the past.
    Resulting in lower exports.
    These speculators will kill every product category.

  • Guruprasad V says:

    If Government didn’t accept this deal, then how its possible for them to run as an exchange for 3 years. All are involved. No doubt in this. Coincidentally I was attending a meet on Commodities and a MCX guy was explaining about this guaranteed NSEL deal. I asked him how it could be possible anywhere to get a guaranteed returns( I don’t have any knowledge about this NSEL) ? He answered me most of his friends have been doing this guaranteed deal for the past couple of years. I was astonished and I felt low that I didn’t have any knowledge about this guaranteed stuff. This meet happened just before a week and now from my sources, I come to know that there are high probability of default in this transaction done by the exchange. So there is no free money and there is definitely not guaranteed money. Its identical to writing options until one fine morning markets completely goes whack in opposite direction of your position (Like 2008 January consecutive lower freeze and 2009 election result upper freeze. Put Writers and Call Writers on these occasion might have burnt their fingers in a big way).

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  • sriram says:

    In a different post, I asked if this raises doubts over the bullion stock (stored in Brinks Arya Vaults) purchased via e-series. Later, I researched a bit and found these audit reports for bullion (of course, the auditor disowns all liability for any discrepancy).
    And today, there’s a report in ET stating:
    “FMC and the consumer affairs department are expected to tell NSEL to stop the sale of e-series certificates in bullion and other metals as the government believes that the nature of these contracts is also forward and not spot as has been claimed by the exchange.”

  • Niftytrader says:

    Excellent piece, Deepak. I must congratulate you on your research. It gives a very clear picture of the events as they unfolded. As an NSE member myself, we too were approached with this guaranteed arbitrage and i recall laughing out in the face of the proposer when he told me that we can get 16% risk free returns !
    A ponzi has to fail. Has to fail . It has now.
    I must also congratulate you on having a very intelligent following. The comments on your site are quite read worthy unlike silly ones elsewhere.
    My personal belief is that we have only seen the tip of the iceberg in this matter and it will not stop at FTIL . It will spread to MCX and these developments may as well cause a big crack in the equity markets in the coming days. Brace..Brace.. Brace..

  • chirag says:

    nice piece deepak. you have raised the right questions, lets see whether this govt comes up with a credible investigation and replies. the outlook story you alluded to is pointing fingers in the right direction. no scam of this size or any size is possible without active connivance of the political class. i would not be surprised if the investigation comes up with nothing. when they go right to the end, some political big wig is likely to get burnt, and that will not happen in this great country of ours. you are bang on about this creating a deficit far worse than the current and fiscal, the TRUST DEFICIT.